Part-07

An Introduction to Fixed
Income Securities

10/22/08 1
Basics
 What is debt?
 It is a financial claim.
 Who issues is?
 The borrower of funds

For whom it is a liability
 Who holds it?
 The lender of funds
 For whom it is an asset
10/22/08 2
Basics (Cont…)
 What is the difference between
debt and equity?
 Debt does not confer ownership rights
on the holder.
 It is merely an IOU

A promise to pay interest at periodic
intervals and to repay the principal itself
at a prespecified maturity date.

10/22/08 3
Basics (Cont…)
 It usually has a finite life span
 The interest payments are contractual
obligations
 Borrowers are required to make
payments irrespective of their financial
performance
 Interest payments have to be made
before any dividends can be paid to
equity holders.
 In the event of liquidation
10/22/08
 The claims of debt holders must be settled 4
first
Plain Vanilla & Bells and
Whistles
 The most basic form of a bond is
called the Plain Vanilla version.
 This is true for all securities, not
just for bonds.
 More complicated versions are said
to have
`Bells and Whistles’ attached.

10/22/08 5
Face Value
 It is the principal value underlying
the bond.
 It is the amount payable by the
borrower to the lender at maturity.
 It is the amount on which the
periodic interest payments are
calculated.

10/22/08 6
Term to Maturity
 It is the time remaining in the life
of the bond.
 It represents the length of time for
which interest has to be paid as
promised.
 It represents the length of time
after which the face value will be
repaid.
10/22/08 7
Coupon
 The coupon payment is the
periodic interest payment that has
to be made by the borrower.
 The coupon rate when multiplied
by the face value gives the dollar
value of the coupon.
 Most bonds pays coupons on a
semi-annual basis.

10/22/08 8
 Example of Coupon
Calculation
 Consider a bond with a face value of
$1000.
 The coupon rate is 8% per annum
paid semi-annually.
 So the bond holder will receive
1000 x 0.08
___ = $40 every six months.
2
10/22/08 9
Yield to Maturity (YTM)
 Yield to maturity is the rate of return
that an investor will get if he buys the
bond at the prevailing market price and
holds it till maturity.
 In order to get the YTM, two conditions
must be satisfied.
 The bond must be held till maturity.
 All coupon payments received before
maturity must be reinvested at the YTM.
10/22/08 10
Value of a Bond
 A bond holder gets a stream of
contractually promised payments.
 The value of the bond is the value of
this stream of cash flows.
 However you cannot simply add up cash
flows which are arising at different
points in time.
 Such cash flows have to be discounted
before being added.
10/22/08 11
Price versus Yield
 Price versus yield is a chicken and
egg story, that is, we cannot say
which comes first.
 If we know the yield that is
required by us, we can quote a
price accordingly.
 Similarly, once we acquire the
asset at a certain price, we can
work out the corresponding yield.
10/22/08 12
Bond Valuation
 A bond is an instrument that will pay
identical coupon payments every
period, usually every six months, for a
number of years, and will then repay
the face value at maturity.
 The periodic cash flows obviously
constitute an annuity.
 The terminal face value is a lump sum
payment.
10/22/08 13
Bond Valuation (Cont…)
 Consider a bond that pays a semi-
annual coupon of $C/2, and which has a
face value of $M.
 Assume that there are N coupons left,

and that we are standing on a coupon

payment date.
 That is, we are assuming that the next

coupon is exactly six months away.

 The required annual yield is y, which

implies that the semi-annual yield is y/2.

10/22/08 14
Bond Valuation (Cont…)
 The present value of the coupon
stream is:

10/22/08 15
Bond Valuation (Cont…)
 The present value of the face value
is:

10/22/08 16
Bond Valuation (Cont…)
 So the price of the bond is:

10/22/08 17
Illustration
 IBM has issued a bond with a face
value of $1,000.
 The coupon is 8% per year to be

paid on a semi-annual basis, on

July 15 and January 15 every year.
 Assume that today is 15 July 2002

and that the bond matures on 15

January 2022.
 The required yield is 10% per

annum.
10/22/08 18
Illustration (Cont…)

10/22/08 19
Par, Discount & Premium
Bonds
 In the above example, the price of the
bond is less than the face value of
$1,000.
 Such a bond is called a Discount Bond,
since it is trading at a discount from the
face value.
 The reason why it is trading for less
than the face value is because the
required yield of 10% is greater than
the rate of 8% that the bond is paying
10/22/08 20
Par, Discount & Premium
Bonds (Cont…)
 If the required yield were to equal the
coupon rate, the bond would sell for
$1,000.
 Such bonds are said to be trading at

Par.
 If the required yield were to be less than

the coupon rate the price will exceed

the face value.
 Such bonds are called Premium Bonds,

since they are trading at a premium

10/22/08 21
Zero Coupon Bonds
 A Plain Vanilla bond pays coupon
interest every period, typically every six
months, and repays the face value at
maturity.
 A Zero Coupon Bond on the other hand

does not pay any coupon interest.

 It is issued at a discount from the face

value and repays the principal at

maturity.
 The difference between the price and

the face value constitutes the interest 22

10/22/08
Illustration
 Microsoft is issuing zero coupon
bonds with 5 years to maturity and
a face value of $10,000.
 If you want a yield of 10% per
annum, what price will you pay?
 The price of the bond is obviously
the present value of a single cash
flow of $10,000, discounted at
10%.
10/22/08 23
Illustration (Cont…)
 In practice, we usually discount the
face value using a semi-annual
rate of y/2, where y in this case is
10%.
 This is to facilitate comparisons
with conventional bonds which pay
coupons interest every six months.

10/22/08 24
Zero Coupon Bonds
(Cont…)
 Zero coupon bonds are called
zeroes by traders.
 They are also referred to as Deep
Discount Bonds.
 They should not be confused with
Discount Bonds, which are Plain
Vanilla bonds which are trading at
a discount from the face value.

10/22/08 25
Treasury Securities
 They are fully backed by the
federal government or the central
government of the issuing nation.
 Consequently they are devoid of
credit risk or the risk of default.
 The interest rate on such securities
is used as a benchmark for setting
rates on other kinds of debt.

10/22/08 26
U.S. Treasury Securities
 The Treasury issues three
categories of marketable
securities.
 T-bills are discount securities
 They are issued at a discount from
their face values and do not pay
interest.
 T-notes and T-bonds are sold at
face value and pay interest
10/22/08 27
U.S. Treasury Securities
(Cont…)
 T-bills are issued with a original
time to maturity of one year or
less.
 Consequently they are Money market
instruments.
 They have maturities of either 3, 6, or
12 months at the time of issue.

10/22/08 28
US. Treasury Securities
(Cont…)
 T-notes and T-bonds have a time
to maturity exceeding one year at
the time of issue.
 They are therefore capital market
instruments.
 T-bonds have an original maturity in
excess of 10 years, extending up to
30 years.

10/22/08 29
U.S. Treasury Securities
(Cont…)
 T-notes are similar to T-bonds
except that their terms to maturity
range from one to ten years.
 Notes and bonds are issued in
amounts which range from 8-15
billion USD.
 Bonds for which further tranches are
issued can reach outstanding
amounts of 20 billion USD or more
10/22/08 30
U.S. Treasury Securities
(Cont…)
 The issuance of further tranches is
termed as a Re-opening.
 For instance, if a 20 year bond with a
current time to maturity of 15 years is
re-opened then an additional issue of
15 year bonds with the same coupon
will be made to add to the
outstanding amount in the market.

10/22/08 31
U.S. Treasury Securities
(Cont…)
 The secondary market is liquid and
transparent and trades take place
through banks and primary
dealers.
 Securities are also listed on the

NYSE to accommodate overseas

investors who may be permitted
by regulations to trade only in
listed securities.
10/22/08 32
U.S. Treasury Securities
(Cont…)
 Settlement is arranged through
FEDWIRE, which is the Federal
Reserve’s wire transfer system
 Foreign investors need to arrange for
a local custodian with access to
FEDWIRE.
 Three month and six month bills
are issued on a weekly basis.
 One year bills are issued every

month.
10/22/08 33
U.S. Treasury Securities
(Cont…)
Issue of T-notes and Bonds
Issue Frequency Auction
Month
2 Year Monthly Every month

3, 10 Year Quarterly Feb, May,

Aug, Nov
5 Year Monthly Every month

30 Year Semi- Feb and Aug

annually
10/22/08 34
U.S. Treasury Securities
(Cont…)
 Interest from these instruments is
exempt from state income taxes.
 Guidelines of Mutual Reciprocity.
 Federal bonds are exempt from state
taxes
 Bonds issued by state governments

are exempt from federal taxes

 The exemption applies only to

interest income.
 Capital gains are taxable at normal
10/22/08 35
rates.
Primary Dealers
 Who is a primary dealer?
 A PD is a bank or securities broker-dealer
that directly deals in U.S. government
securities with the Federal Reserve Bank of
New York.
 As of August 2004 there were 22 primary
dealers, down from a number of 46 in 1988.
 The most important reason is consolidation. That
is many firms have merged or refocused their
core lines of business.

10/22/08 36
Primary Dealers (Cont…)
 The FED requires primary dealers
to participate meaningfully in both
open market operations as well as
Treasury Auctions.
 The current list of primary dealers
is as follows.

10/22/08 37
List of Primary Dealers
 ABN Amro bank
 Banc of America
Securities
 Bear, Stearns & Co.
 Citigroup Global Markets
 Credit Suisse First Boston
 Deutsche Bank Securities
 Goldman Sachs
 HSBC Securities
 Lehman Brothers
 Mizuho Securities
 Nomura Securities
10/22/08
 BNP Paribas Securities
Corp.
 Barclays Capital
 CIBC World Markets
 Countrywide Securities
Corp.
 Daiwa Securities America
 Dresdner Kleinwert
Wasserstein
 Greenwich Capital
Markets
 J.P. Morgan Securities
 Merrill Lynch
Government Securities
 Morgan Stanley
 UBS Securities 38
Treasury Auctions
 The U.S. Treasury sells bills, notes,
and bonds by way of a competitive
auction process.
 Most of the treasury securities are
bought by primary dealers.
 Individual investors who submit
non-competitive bids participate
on a much smaller scale.

10/22/08 39
Treasury Auctions (Cont…)
 The auction process begins with a
public announcement by the
Treasury giving the following
information.
 Offering amount
 Description of the offering
 Strips information

Is the security eligible for stripping
 Procedures for submission of bids;
minimum bid amount; and payment
10/22/08 40
terms
Treasury Auctions (Cont…)
 Description of the offering
includes:
 Term and type of security
 CUSIP number
 Auction date
 Issue date
 Dated date
 Maturity date
 Interest payment dates
10/22/08 41
Treasury Auctions (Cont…)
 Bids may be:
 Competitive
 Non-competitive
 Small investors and individuals generally
submit non-competitive bids
 The bidder merely indicates the quantity sought
 The price is determined by the auction process
 A non-competitive bidder may not bid for more
than $1MM worth of securities in a bill auction
 Or more than 5 million in a note or bond auction

10/22/08 42
Treasury Auctions (Cont…)
 Primary dealers who bid for their
accounts or on behalf of their clients
usually submit large competitive bids
 These bids indicate not only the quantity
that is sought
 But also the maximum price that the bidder
is prepared to pay if it is a price based
auction
 Or the minimum yield that the bidder is
prepared to accept if it is a yield based
auction
10/22/08 43
Treasury Auctions (Cont…)
 Bidders are forbidden from bidding
both competitively and non-
competitively for the same account
in the same auction.
 Competitive bidders can submit
multiple bids
 But no bidder may receive more than
35% of the security being sold.
10/22/08 44
Treasury Auctions (Cont…)
 Bids are submitted in terms of
discount rates for bills
 Stated in 3 decimal places
 In 0.005 percent increments
 In note and bond auctions
 They are expressed as yields up to 3
decimal places
 In 0.001 percent increments

10/22/08 45
Treasury Auctions (Cont…)
 Competitive bids are accepted till
1:00 p.m. EST on the day of the
auction
 The deadline for non-competitive
bids is 12:00 EST on the auction
date

10/22/08 46
Treasury Auctions (Cont…)
 Once the bids are received the Treasury
will net out the total amount of non-
competitive bids and will begin
allocating the balance to competitive
bidders.
 There are two ways in which securities
can be allotted
 The multiple price/yield auction mechanism
 The uniform price/yield auction mechanism

10/22/08 47
Illustration
 Assume that the Treasury is
offering 15 billion dollars worth of
T-bonds.
 2 billion dollars worth of non-

competitive bids have been

received.
 So 13 billion dollars worth of bonds

are available to be offered to the

competitive bidders.
10/22/08 48
Illustration (Cont…)
 Assume that there are six
competitive bidders who have
submitted the following yields.
 The bids have been arranged in
ascending order of yield.
 Had it been a price based auction the
bids would have been arranged in
descending order of price.

10/22/08 49
Illustration (Cont…)
Bidder Bid Yield Bid Aggregat
Amount e Amount
Alpha 5.370 3.0 bn 3.0 bn
Beta 5.372 3.0 bn 6.0 bn
Gamma 5.373 4.0 bn 10 bn
Delta 5.375 3.0 bn 13 bn
Charlie 5.375 2.0 bn 15 bn
Tango 5.380 2.0 bn 17 bn
10/22/08 50
Illustration (Cont…)
 The aggregate demand equals the
amount on offer at a yield of
5.375.
 A multiple yield auction will lead to
the following allocation.
 Alpha will get 3 bn at a yield of 5.370
 Beta will get 3 bn at 5.372
 Gamma will get 4 bn at 5.373
10/22/08 51
Illustration (Cont…)
 By the time we reach a yield of
5.375 we have only 3 bn left to
allocate.
 There is a demand of 5 bn at this
yield
 3 bn from Delta and 2 bn from
Charlie.
 So there will be pro-rata allocation

10/22/083/5 of 3 bn or 1.8 bn will go to Delta 52
Illustration (Cont…)
 The highest yield that is accepted
at the auction is called the Stop
Yield
 In this case it is 5.375
 The ratio of bids received to the
amount awarded is known as the
bid to cover ratio
 The higher the ratio the stronger is
10/22/08
the auction 53
Illustration (Cont…)
 The difference between the
average yield of all accepted bids
and the stop yield is called the tail
of the auction.
 A multiple price/yield auction is
also known as a discriminatory
auction
 Since each successful bidder is
10/22/08
allotted at the price/yield bid by him 54
Illustration (Cont…)
 The second type of auction is called a
uniform price/yield auction.
 In our case aggregate demand is equal
to the supply at a yield of 5.375%.
 Consequently everyone who bid less will
be allotted the quantities sought by
them at this yield.
 The two bidders at 5.375 will also be
awarded at this yield but on a pro-rata
basis.
10/22/08 55
Illustration (Cont…)
 Those who bid more than 5.375
will get nothing and are said to be
shutout of the auction.
 Since 1999 the U.S. Treasury has
been conducting only uniform yield
auctions.

10/22/08 56
Treasury Auctions (Cont…)
 The auction results are released to the
public within two hours of the auction.
 The following information is made
public:
 The amount of bids received
 The total bids accepted
 The bid to cover ratio
 High, low and median bids
 The issue price

10/22/08 57
Illustration-I: A Real
Treasury Auction
 Announcement date: 2 August
 Offering amount: $ 10 billion
 Term and type of security:
 4 ¾ year note (reopening of a 5 year note)
 Series: E 2005
 CUSIP No.: 912827 6D9
 Auction date: 8 August 2000
 Issue date: 15 August 2000
 Dated date: 15 May 2000
 Maturity date: 15 May 2005

10/22/08 58
Illustration-I (Cont…)
 Interest rate: 6 3/4 %
 Amount currently outstanding: $15.426
billion
 Yield: To be determined at the auction
 Interest payment dates: 15 November and
15 May
 Minimum bid amounts and multiples: $
1,000
 Premium or discount: To be determined at
the auction
10/22/08 59
Analysis
 This auction is a re-opening of a 5 year
note issued on 15 May 2000.
 Consequently the securities being issued
have 4 ¾ years to maturity.
 Although the auction is announced on 2
August the actual auction date is 8
August.
 The securities will however be issued
only on 15 August.
 The dated date is 15 May which is when
the original 5 year security was issued.
10/22/08 60
Analysis (Cont…)
 The dated date is different from the
issue date because the issue is being
reopened.
 The maturity date is 15 May 2005.
 The interest rate or the coupon is known
since the security is already trading in
the market.
 The yield will be determined at the
auction.
 Consequently the issue price and the
premium/discount with respect to the face
10/22/08 61
value will also be determined at the auction.
Illustration-II
 Auction announcement date: 2 August
 Offering amount: 10 billion
 Term and type of security: 10 year note
 Series: C 2010
 CUSIP No.: 912827 6J6
 Auction date: 9 August 2000
 Issue date: 15 August 2000
 Dated date: 15 August 2000
 Maturity date: 15 August 2010

10/22/08 62
Illustration-II (Cont…)
 Interest rate: Determined based on the
highest accepted competitive bid
 Amount currently outstanding: Not

applicable
 Yield: Determined at auction

 Interest payment dates: 15 Feb and 15

August
 Minimum bid amounts and multiples: $

1,000
 Premium/discount: To be determined at

the auction
10/22/08 63
Analysis
 This auction represents a fresh issue of
a 10 year T-note
 The coupon rate is unknown at the
outset since it will be fixed based on the
bids received.
 Assume that the market clearing yield is
4.920%
 The coupon will be set after rounding down
the winning bid to the nearest multiple of
1/8th which in this case is 4.875%.
10/22/08 64
Zero Coupon Treasury
Securities
 The Treasury per se does not issue zero
coupon securities.
 But there exist two types of treasury
based zero coupon securities.
 The principle behind both forms is the
same.
 Take a large quantity of a T-note or bond
and separate all the coupons from each
other and from the principal.
 Sell the entitlement to each cash flow

10/22/08
separately. 65
Zero…(Cont…)
 Take the case of a two-year T-note.
 It can be separated into four zero
coupon securities maturing after:
 6 months
 12 months
 18 months
 24 months

10/22/08 66
Zero…(Cont…)
 Earlier investment banks used to
buy regular coupon bonds from the
Treasury and then separate the
cash flows themselves.
 Each cash flow was then sold
separately as a zero coupon bond.
 Such issues are called trademarks.

10/22/08 67
Zero…(Cont…)
 The issue of trademarks has now
ceased.
 This is because investment banks can
now create such instruments in concert
with the Treasury itself.
 These zero coupon bonds are known as
STRIPS – Separate Trading of Registered
Interest and Principal of Securities.
 These are not issued or sold by the Treasury
 The market is made by investment banks.

 But such issues are considered to be an

10/22/08 68
obligation of the Treasury.
Trademark Products
 Some of the older trademark
products which have not yet
matured continue to trade.
 The process of issuing trademarks
was begun by Merrill Lynch and
Salomon Brothers in 1982.
 These securities are synthetic zero
coupon Treasury receipts.
10/22/08 69
Trademarks (Cont…)
 The procedure for issuing them is
as follows:
 The bank concerned would purchase
a Treasury coupon bearing security
and deposit it in a bank custody
account.
 It would then issue receipts

representing an ownership interest in

each coupon payment on the
10/22/08underlying asset, as well as a receipt 70
Trademarks (Cont…)
 The process of separating each coupon
payment as well as the principal and selling
securities backed by them is referred to as
Coupon Stripping.
 The receipts issued in the process are not
created by the Treasury.
 But the underlying asset in the bank

custody account is an obligation of the

Treasury.
 Thus the cash flows from the underlying

asset are guaranteed.

10/22/08 71
Example
 Assume that a bank purchases
$100 MM worth of a Treasury note
with a 10 year maturity and a
coupon of 10%.
 This note will yield 20 coupon
payments of $5 million each and a
final principal repayment of $100
million.
 This note will be deposited in a
custody account.
10/22/08 72
Example (Cont…)
 21 zero coupon securities will then
be issued.
 Each will represent a claim on one
cash flow from the underlying
security.
 The first 20 such securities will have a

face value of $5 million.

 The last will have a face value of

$100 MM.
 The maturity dates for the receipts

10/22/08will coincide with the coupon 73

Trademarks (Cont…)
 Merrill Lynch marketed its Treasury
receipts as Treasury Income
Growth Receipts – TIGRS for short.
 Salomon Brothers called its

receipts as Certificates of Accrual

on Treasury Securities – CATS for
short.
 Lehman Brothers offered Lehman

Investment Opportunities Notes or

LIONS for short.
10/22/08 74
Trademarks (Cont…)
 These securities are called
trademarks because each is
associated with a particular
investment banking firm.
 They are called Animal Products

for obvious reasons.

 This segment of the financial

market was also referred to as the

Zoo.
10/22/08 75
Trademarks (Cont…)
 Receipts created by one firm were
rarely traded by others.
 So the secondary market was illiquid.
 What is the motivation for investment
banks to create such products?
 In practice arbitrage is possible when a

Treasury coupon security is purchased

at a price that is lower than what could
be obtained by selling each cash flow
separately.
10/22/08 76
STRIPS
 The Treasury launched this
programme in 1985 to facilitate
the stripping of designated
Treasury securities.
 All new T-bonds and notes with a
maturity of 10 years or more are
eligible.
 The zeroes created in the process are

direct obligations of the U.S.

10/22/08government. 77
 STRIPS (Cont…)
 On dealer quote sheets and
vendor screens, STRIPS are
identified as follows.
Cash Flow Source Symbol
Coupon ci
Principal from T- bp
bond
Principal from T- np
note
10/22/08 78
Floating Rate Bonds
 In the case of a Plain Vanilla Bond, the
coupon rate that is specified at the
outset, is valid for the life of the bond.
 In the case of a Floating Rate bond, the
coupon rate is reset at the beginning of
every period, and is therefore valid for
only the next six months.
 Thus when you buy such a bond, the
coupon will be known only for the first
six months. Subsequent coupons will be
10/22/08 79
Floaters
 For instance the rate on a floating rate
bond, also called a Floater, may be
specified as LIBOR + 50b.p. in which
case the spread is positive.
 Or it may be specified as LIBOR –

30b.p., in which case the spread is

negative.
 The rate of interest on a floater will

move directly with changes in the

benchmark.
 Thus if LIBOR rises, the rate will
10/22/08 80
Inverse Floaters
 In the case of an inverse floater the
coupon varies inversely with the
benchmark.
 For instance the rate on an inverse

floater may be specified as 10% -

LIBOR.
 In this case as LIBOR rises, the coupon

will decrease, whereas as LIBOR falls,

the coupon will increase.
 In this case a floor has to be specified

for the coupon.

10/22/08 81
Inverse Floaters (Cont…)
 In the absence of a floor the
coupon can become negative in
principle.
 In the above case, if LIBOR were to
exceed 10%, then we would be
confronted with the spectre of a
negative coupon.

10/22/08 82
Callable Bonds
 In the case of such a bond, the issuer
has the right to call back the bond
prematurely.
 That is he can buy it back from the

holder before maturity by paying him

the face value.
 In this case the option is with the issuer,

and so he has to pay a price for it.

 This compensation will manifest itself as

a lower price for the bond as compared

to a Plain Vanilla Bond.
10/22/08 83
Callable Bond (Cont…)
 Since prices and yields are inversely
related a lower price means a higher
yield.
 Thus buyers of callable bonds demand a
higher yield from them as compared to
buyers of otherwise similar plain vanilla
bonds.
 This is because a buyer of a callable
bond is exposed to cash flow
uncertainty. That is, he can never be
10/22/08 84
Callable Bonds (Cont…)
 When will a callable bond be recalled?
 Obviously when interest rates or

required yields are falling.

 Under such conditions, the issuer can

call back the bonds and issue fresh

bonds with a lower coupon.
 However this is precisely the scenario

when a holder would like to hold on to

his bonds, since they are yielding a
higher rate of interest.
10/22/08 85
Callable Bond (Cont…)
 Thus the call provision works in
favour of the borrower and against
the lender.
 Hence it is not surprising that

callable bonds command a lower

price.
 Freely callable bonds can be called

at any time.
 Thus they offer the lender no
10/22/08 86
Callable Bonds (Cont…)
 Deferred Callable Bonds on the other
hand do offer some protection.
 This is because they have a Call
Protection Period during which they
cannot be recalled.
 For instance if a bond with 20 years to
maturity has a call protection period of
10 years, then it cannot be recalled for
the first 10 years. After that, it will of
course become freely callable.
10/22/08 87
Callable Bond (Cont…)
 In practice when a bond is recalled,
the issuer will pay the lender not
just the face value, but usually also
one year’s coupon.
 This additional amount is called

the Call Premium.

 The call premium acts as a

sweetener, that is it makes such

bonds more attractive to potential
investors.
10/22/08 88
Callable Bond (Cont…)
 One of the risks in a callable bond
is therefore reinvestment risk
 That is, the bond will be called back
when market rates are low and
consequently the proceeds will have
to be invested at a lower rate of
interest.

10/22/08 89
Callable Bond (Cont…)
 Second, the price appreciation
potential for a callable bond in a
declining interest rate environment
is limited.
 This is because the market will
increasingly expect the bond to be
redeemed at the call price as rates
fall.
 This is referred to as Price

10/22/08Compression. 90
Callable Bond (Cont…)
 Given the reinvestment risk and
price compression why would any
investor want to hold such a bond.
 If he receives sufficient compensation
in the form of a higher yield he may
be willing to take the risk.

10/22/08 91
Puttable Bonds
 Such bonds give the lender or the
bondholder, the right to return the bond
prematurely, and take back the face
value.
 The option in such cases is with the
bondholders or the lenders, and
consequently they have to pay an
option premium.
 This will manifest itself as a higher bond
price, as compared to that of an
10/22/08 92
Puttable Bonds (Cont…)
 A higher bond price obviously means a
lower yield.
 When will such a put option be

exercised?
 Obviously when interest rates are rising.

 Under such conditions holders can

return the bonds and buy fresh bonds

with a higher coupon rate.
 This is precisely the scenario when the

issuers would prefer that the holders

hold on to the bonds.
10/22/08 93
Puttable Bonds (Cont…)
 Since the put option works in favour of
the holder and against the issuer, it is
but natural that such bonds are
characterized by higher prices or lower
yields.
 The price at which a bond can be sold

back by the holder acts as a floor price

for the bond when interest rates rise.
 Since the holders can always return the

bonds to the issuer at this price, they

will never sell them to anyone else at a
lower price.
10/22/08 94
Convertible Bonds
 A conversion provision, if present
in the bond, grants the bondholder
the right to convert the bond into a
predetermined number of shares
of common stock of the issuer.
 It is therefore a Plain Vanilla
corporate bond with a call option to
buy the common stock of the issuer.

10/22/08 95
Convertible Bonds (Cont…)
 The number of shares of common stock
that a bondholder will receive if he
converts the bond is called the
Conversion Ratio.
 The conversion privilege may extend for all
or only some portion of the bond’s life.
 The stated conversion ratio may also
decline over time.
 The conversion ratio is always adjusted
proportionately for stock splits and stock
dividends.
10/22/08 96
Convertible Bonds (Cont…)
Illustration
 ABC Corporation has issued the
following bond
 Maturity = 10 years
 Coupon rate = 8%
 Conversion ratio = 40
 Face value = $1,000
 Current market price = $900
 Current share price = $20
 Dividends per share = $1

10/22/08 97
Convertible Bonds (Cont…)
 The conversion price = 1000
------- = $25
40
 The conversion value of a
convertible bond is the value if it is
converted immediately.
 Conversion value = Share price x
Conversion
Ratio
10/22/08 98
Convertible Bond (Cont…)
 The minimum price of a
convertible bond is the greater of:
 Its conversion value or
 Its value as a bond without the
conversion option . This is also called
the straight value of the bond.

10/22/08 99
Convertible Bond (Cont…)
 To estimate the straight value we
must determine the required yield
on a non-convertible bond with the
same credit rating and similar
investment characteristics.

10/22/08 100
Convertible Bond (Cont…)
 In our case the conversion value is
 $20 x 40 = $800
 To determine the straight value we
have to obtain the YTM of a
comparable straight bond. Assume
it is 10%.
 Straight value =
40PVIFA(5,20)+1000PVIF(5,20)
= $875.38
10/22/08 101
Exchangeable Bonds
 These are a category of convertible bonds
where the holder gets the shares of a different
company when he converts the bonds.
 For instance if IBM were to issue convertible
bonds, the holders would get shares of IBM if
they were to convert.
 On the other hand, if IBM were to issue
exchangeable bonds, the holders would get
shares of another company, say Hewlett
Packard.

10/22/08 102
Exchangeable Bonds
(Cont…)
 Exchangeable bonds may be
issued by firms which own blocks
of shares of another company and
intend to sell them eventually.
 They may like to defer the sale and

issue such bonds, because they

may perceive a rise in the value of
the shares.
 It may also be the case that they

desire to defer their capital gains 103

10/22/08
Risks Inherent in Bonds
 What is risk?
 Risk is the possibility of loss arising
due to the uncertainty regarding
the outcome of a transaction.
 All bonds are exposed to one or
more sources of risk.

10/22/08 104
Credit Risk
 This risk refers to the possibility of
default by the borrower.
 That is, it refers to the risk that coupon
payments and/or principal payments
may not be forthcoming as promised.
 Except for Treasury securities, which
are backed by the full faith and credit of
the Federal government, all debt
securities are exposed to credit risk of
varying magnitudes.
10/22/08 105
Credit Evaluation
 At the time of issue, it is the issuer’s
responsibility to provide accurate
information about his financial
soundness and creditworthiness.
 This is provided in the Offer Document

or the Prospectus.
 But every potential investor cannot be

expected to be able to properly

evaluate the creditworthiness of a
borrower.
 Thus in practice we have credit rating
10/22/08 106
Credit Rating Agencies
 Such agencies specialize in evaluating
the credit quality of a bond at the time
of issue.
 They also monitor the issuing company,
throughout the life of the bond, and
modify their recommendations if
required.
 The main rating agencies in the U.S. are
Moody’s Investors Service, Standard
and Poor’s Corporation and Fitch
Ratings.
10/22/08 107
Rating Criteria
 Ratings are based on an in-depth
analysis of the issuer’s financial
condition and management, and
the specific source of revenue that
has been specified as collateral for
the bond.

10/22/08 108
 Investment Grade Ratings
Credit Moody’s S&P’s Fitch’s
Risk Ratings Ratings Ratings
Highest Aaa AAA AAA
Quality
High Aa AA AA
Quality
Upper A A A
Medium
Medium Baa BBB BBB
10/22/08 109
 Non Investment Grade
Ratings
Credit Risk Moody’s S&P Fitch

Somewhat Ba BB BB
Speculative
Speculative B B B

Highly Caa CCC CCC

Speculative
Most Ca CC CC
Speculative
Imminent C C C
Default
Default C D D
10/22/08 110
Changes in Ratings
 Ratings can change over the
course of time.
 If a rating change is being

contemplated, the agency will

signal its intentions.
 S&P will place the security on

Credit Watch.
 Moody’s on Under Review.

 Fitch on Rating Watch.

10/22/08 111
Bond Insurance
 A company can have its issue
insured in order to enhance its
credit quality.
 An insurance premium will have to

be paid, but the coupon rate will

come down.
 The insurance company will then

guarantee the timely payment of

the principal and interest.
10/22/08 112
 List of Specialist Insurance
Companies

American Municipal Bond Assurance Corporation (AMBAC)

ACA Financial Guaranty
Asset Guaranty Insurance Company
AXA Re Finance
Capital Guaranty Insurance Company
Capital Reinsurance Company
Enhance Reinsurance Company
Financial Guaranty Insurance Company
Financial Security Assurance
Municipal Bond Insurance Association
10/22/08 113
Insured Bonds
 Insured bonds receive the same
rating as the insurance company,
which is based on the insurer’s
capital and claims-paying ability.
 In the U.S., the buyer of an
uninsured bond can separately buy
insurance for it on his own.

10/22/08 114
Liquidity Risk
 This risk refers to the possibility
that the market may be illiquid or
thin at a time when the asset
holder wants to buy or sell the
security.
 A liquid market is characterized by

the presence of a sizeable number

of buyers and sellers at any point
in time.
10/22/08 115
Illiquid Markets
 In illiquid markets, potential buyers
will have to offer a large premium
over the fair value of an asset in
order to acquire it, whereas
potential sellers will have to accept
large discounts at the time of sale.
 Illiquid markets are characterized

by large bid-ask spreads, because

trades will be few and far between.
10/22/08 116
Interest Rate Risk
 The interest rate or yield is the key
variable of interest in debt
markets.
 The yield is the fundamental
variable that drives the market.
 Interest rate risk refers to the fact
that rates may move in an adverse
fashion from the standpoint of the
holder of the debt instrument.
10/22/08 117
Interest Rate Risk
 Interest rate risk impacts fixed
income securities in two ways.
 Firstly, all bonds with the
exception of zeroes pay coupons,
which have to be reinvested.
 Reinvestment risk is the risk that
market rates of interest may
decline by the time a coupon is
received.
10/22/08 118
Interest Rate Risk (Cont…)
 If so, the coupon will have to be
reinvested at a lower than
anticipated rate of interest.
 Secondly a bond may not be held

to maturity.
 If it is sold prior to maturity, it will

have to be at the prevailing market

price, which will be inversely
related to the prevailing yield.
10/22/08 119
Interest Rate Risk (Cont…)
 Market Risk or Price Risk, is the risk that
interest rates may be higher than
anticipated at the time of sale, in which
case the bond will have to be sold at a
lower than anticipated price.
 The two risks work in opposite
directions.
 Reinvestment risk arises because rates
may fall subsequently, whereas market
risk arises because rates may rise
10/22/08 120
Inflation Risk
 Inflation refers to the erosion in the
purchasing power of money.
 Most bonds promise fixed cash

flows in dollar terms.

 Inflation risk is the risk that the

purchasing power of money may

have eroded by more than what
was anticipated, by the time the
cash flow from the bond is
received.
10/22/08 121
Inflation Risk (Cont…)
 High inflation will reduce the
effective or Real rate of interest.
 The interest rate in monetary
terms is called the Nominal Rate of
interest.
 The Real Rate, on the other hand,
is the nominal rate adjusted for
changes in the purchasing power.
10/22/08 122
Indexed Bonds
 These are bonds whose coupons
are linked to a price index.
 Price indices are used as
barometers of changes in the
purchasing power of a currency.
 If inflation is high, so will be the
index level and vice versa.

10/22/08 123
Indexed Bonds (Cont…)
 Thus indexed bonds will offer
higher cash flows during times of
high inflation, and relatively lower
cash flows during periods of lower
inflation, which will ensure that the
cash flow in real terms is kept at a
virtually constant level.

10/22/08 124
Timing Risk
 In the case of Plain Vanilla bonds, there
is no uncertainty regarding the times to
receipt of the cash flows.
 However, callable bonds can be recalled
at any time.
 For a callable bond holder there is cash
flow uncertainty, since he is unsure as
to how many periods he is going to get
coupons for, and also as to when the
face value will be repaid.
10/22/08 125
Timing Risk (Cont…)
 Thus holders of callable bonds will
demand a premium for bearing
this risk.
 That is why callable bonds trade at
a lower price than otherwise
comparable plain vanilla bonds.

10/22/08 126
Foreign Exchange Risk
 This risk arises when the cash
flows from a bond are
denominated in a foreign currency.
 If the foreign currency depreciates

in value with respect to the home

currency of the bondholder, then
when the cash flows from the bond
are converted into the home
currency, the returns will be lower127
10/22/08
Illustration
 A bond promises to pay a coupon of $10
every six months.
 Assume that the rate of exchange is Rs
50 per dollar.
 So an Indian bondholder will expect to
receive Rs 500 every six months.
 However, what if the exchange rate at
the time of the coupon payment is Rs
45.
 If so, he will receive only Rs 450.
10/22/08 128